H. A. Carey Co. v. Commissioner

H. A. Carey Co., Inc., Petitioner, v. Commissioner of Internal Revenue, Respondent H. A. Carey Co. v. Commissioner Docket No. 61679 United States Tax Court 29 T.C. 42; 1957 U.S. Tax Ct. LEXIS 65; October 15, 1957, Filed *65 Decision will be entered for the respondent. Petitioner operates an insurance agency. It kept its books on an accrual method and returned its income in accordance with that method. During the years 1930 to 1952, inclusive, it made bookkeeping errors, the effects of which were to overstate gross income and understate accounts payable in the aggregate amount of $ 23,140.73. In 1953, petitioner discovered its error and made an adjusting entry reducing its gross income and increasing its accounts payable by that amount. Petitioner returned the reduced amount as gross income. Respondent increased petitioner's gross income by the same amount. Held, for the respondent. Petitioner is not entitled to reduce its 1953 income, nor is it entitled to a deduction from 1953 gross income for the aggregate amount which, because of bookkeeping errors, was erroneously included in income in prior years. Harrop A. Freeman, Esq., for the petitioner. James J. Quinn, Esq., for the respondent. Black, Judge. BLACK *42 The Commissioner has determined a deficiency in income tax for the taxable (calendar) year ended December 31, 1953, in the amount of $ 7,074.56. Respondent determined that petitioner's commissions on insurance premiums were understated on its income tax return for the taxable year 1953 by the amount of $ 23,140.73. Petitioner concedes the correctness of respondent's adjustment*67 in his statutory notice of deficiency, disallowing the deduction for depreciation in the *43 taxable year 1953 to the extent of $ 441.11. Although the statement explaining the deficiency, which was attached to the deficiency notice, was not made part of the record herein, it appears that the entire deficiency is due to the two aforementioned adjustments. The petitioner, by appropriate assignment of error, has placed the first adjustment in issue. The only question involved is whether the petitioner is entitled to reduce its gross income by the amount of $ 23,140.73, or whether it is entitled to a deduction from gross income in the same amount. The $ 23,140.73 in question represents the total amount erroneously included in income by petitioner for the years 1930 to 1952, inclusive, because of bookkeeping errors during those years. FINDINGS OF FACT. Most of the facts have been stipulated; they are found accordingly, and are incorporated herein by this reference. Petitioner H. A. Carey Co., Inc., a New York corporation, conducts a general insurance agency. For all years relevant hereto it employed an accrual method of accounting in keeping its books and reported its net income*68 in accordance with its books. It filed its Federal income tax return for the calendar year 1953 with the director of internal revenue, Syracuse, New York. Petitioner's method of doing business is as follows: It solicits persons to place insurance with it. When it sells a policy to the insured it issues a policy in such insurance company (hereinafter referred to as insurer) as it selects, notifies the insurer, and soon after the first of the following month bills the insured for the premium. The premium, less the petitioner's commission, is payable to the appropriate insurer. At the end of each month the petitioner makes up an account for each insurer showing the total of premiums on the latter's policies (apportioned as to types, i. e., fire, marine, theft, etc., of insurance), written during the month, less petitioner's commissions thereon, the difference being the amount payable to the latter with respect to sales of insurance policies during the month. Petitioner pays the appropriate insurer on the basis of these accounts, sometime within 30 to 120 days following the preparation of the account. The insurer audits these accounts within 3 or 4 months following their receipt*69 and makes adjustments (representing, for example, canceled and returned policies, insurance rating adjustments, and experience audits of the insured), again apportioned as to types of insurance. These adjustments frequently resulted in the petitioner's owing greater amounts to the insurers. Petitioner reflected these adjustments in the accounts that it prepared for the various insurers at the end of each month. To reflect the above method of doing business during the years 1930 to 1952, inclusive, the petitioner maintained the following accounts *44 in its ledger: (1) An account receivable (debit) for each insured, (2) an income from commissions (credit) account, and (3) one accounts payable control (credit) account for each type of insurance relating to all the insurers. Petitioner did not maintain individual ledger pages for each insurer, the only account on its ledger reflecting its liability to the insurers being the accounts payable control accounts for each type of insurance. Petitioner did keep in a looseleaf binder copies of the monthly statements prepared for each insurer and copies of the audits periodically prepared by the latter. The books were kept by a bookkeeper*70 who had come with the petitioner in the late 1920's and had learned the method of handling the books from the previous bookkeeper; she was otherwise untrained. During the years 1930 to 1952, inclusive, when a policy was sold petitioner entered the amount of the premium due from the insured (debit) in the accounts receivable account relating to the insured, and made two offsetting credits: (1) Entered the amount of its commission in the income from commissions (credit) account, and (2) credited the accounts payable control account for the amount of the premium payable to the insurer. When the insured paid for the policy the petitioner credited the appropriate accounts receivable account and debited cash. When the petitioner paid the insurer it debited the accounts payable control account and credited the cash account. As stated previously, the petitioner paid the insurer on the basis of the accounts that it made up at the end of each month. These accounts reflected any adjustments (frequently increasing the amount due to the insurer) made by the insurer during that month because of audits of accounts for prior months. However, the petitioner failed to reflect these adjustments *71 in its accounts payable control account, i. e., it failed to credit (or increase) its accounts payable control account for the additional amounts due. When the petitioner paid the insurers it reflected the payments by debiting the accounts payable control account and crediting cash. In other words, the entry setting up the liability was not entered correctly but the entry recording the payment, supposedly washing out the liability, was entered correctly. The net result of the failure to properly record the adjustments was that the accounts payable control account was understated and the income from the commissions account was overstated. The aggregate amount of the understatement of accounts payable control account and overstatement of income was $ 23,140.73. The income tax returns of the petitioner for the years 1930 to 1952, inclusive, were prepared in accordance with the books. Accordingly, the aggregate overstatement of income on the returns for the years 1930 to 1952 was $ 23,140.73. *45 The audits by the insurers reflected the correct liability of petitioner as of the date of the audit. This had the effect of the insurers' accruing the liability from the petitioner*72 in each instance in the correct amount. When petitioner paid the insurers, it did not direct the payment to be applied to any specific item but only on the general balance. The insurers did in fact apply payments on the adjusted balances; therefore, on the insurers' books the amounts due from petitioner were correct. At no time during the period from 1930 to 1953 was the correct total balance due from the petitioner to the insurers less than $ 30,000. The balance in the accounts payable control account remained throughout most of the period in excess of $ 50,000. The accounts with the insurers were running accounts. Petitioner never checked the balance shown by the insurers against the balance shown on its own books nor was it aware of its errors until 1953. In 1953, a new accountant was brought into the office and a new attorney engaged. Thereupon a physical check of the monthly accounts made up for the insurers and their audits of these accounts was made. This was checked against the accounts payable control account on the petitioner's books. It was then discovered that the audit statements of the insurers showed petitioner's owing them $ 23,140.73 more than was shown in*73 the petitioner's accounts payable account. A check to determine the reason for this revealed the facts stated above. On the advice of counsel and the accountant, the original errors having been made in the income from commissions and accounts payable control accounts, the adjustment was made by debiting (decreasing) income from commissions account and crediting (increasing) accounts payable control account. The commissions due to petitioner from policies sold in 1953 amounted to $ 158,012.76. The effect of the above-mentioned adjusting entry was to reduce the balance in the income from commissions account to $ 134,872.03 ($ 158,012.76 minus $ 23,140.73). Petitioner reported on its 1953 return as gross income "Commissions on Insurance Premiums" in the amount of $ 134,872.03. Respondent determined that petitioner's commissions on insurance premiums were understated on its income tax return for the taxable year 1953 by the amount of $ 23,140.73 and that the correct amount of commissions on insurance premiums was $ 158,012.76. OPINION. The petitioner operates an insurance agency. It keeps its books on an accrual method and returns its income in accordance with its books. The difference*74 between the premium which is due from the insured to whom it sells an insurance policy, and the amount which is due to the insurer, who issues the policy, represents its *46 commission. It returns these commissions as gross income. The insurers regulary audit the accounts between them and petitioner. Adjustments of the amounts due from petitioner to the insurers (because of cancellation, rate change, etc.) are usually made. The adjustments frequently result in the petitioner's owing the insurers an amount in excess of that originally recorded. For the years 1930 to 1952, inclusive, the petitioner, although it reflected these adjustments correctly in the amounts that it remitted to the insurers, treated the adjustments erroneously on its books. The effect of the erroneous treatment was to overstate its income (on its books and on its returns) and understate its accounts payable (on its books) in the aggregate amount of $ 23,140.73 for those years. In 1953, it discovered its error and made an adjusting entry decreasing its commissions income and increasing its accounts payable by that amount. Its commissions income on its return for 1953 was stated in the decreased amount. *75 The Commissioner increased the petitioner's income by a like amount. The petitioner contends that it is entitled to adjust its 1953 income (either by a reduction of gross income or a deduction from gross income) for the aggregate amount of income erroneously included in its income for the years 1930 to 1952, inclusive. We disagree. The petitioner's commissions on insurance premiums are gross income under section 22 (a), Internal Revenue Code of 1939. 1 Section 42 (a) provides that "[the] amount of all items of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under methods of accounting permitted under section 41, any such amounts are to be properly accounted for as of a different period." The accrual method used by petitioner is a method permitted by section 41. Under the accrual method the petitioner's commissions in 1953 were $ 158,012.76. (Petitioner reported $ 158,012.76 minus $ 23,140.73, or $ 134,872.03 as commissions income.) Petitioner has cited no statutory provision and we know of none permitting a reduction in gross income by the aggregate amount of the improper inclusions in gross income in prior years*76 due to bookkeeping errors in those years. Likewise there is no warrant for a deduction from gross income. Petitioner has not specified which subsection of section 23 it relies upon. We assume that it claims the deduction as a loss under section 23 (f). 2 It is clear, however, that the $ 23,140.73 does not represent a loss and assuming it were a loss it was not sustained in 1953. Cf. Sunburst Oil & Refining Co., 23 B. T. A. 829, 835, 838 (1931); Farmers & Merchants National Bank, 8 B. T. A. 58 (1927). *47 The situation*77 here must be distinguished from instances where the taxpayer receives earnings under a claim of right and later is obliged to return them, see United States v. Lewis, 340 U.S. 590 (1951); North American Oil Consolidated v. Burnet, 286 U.S. 417 (1932), and from instances where the petitioner is denied a deduction in one year because he is contesting the liability which gave rise to the claimed deduction but is later allowed the deduction. See Security Flour Mills Co. v. Commissioner, 321 U.S. 281 (1944). The cases relied on by petitioner involving those situations are not in point. Here the petitioner had full knowledge of the amount of its actual income; it paid the insurers the correct amounts (including adjustments) when due, but because of its erroneous bookkeeping it failed to accurately reflect the transactions as they actually occurred. The principle governing this case is not unlike that involved in J. E. Mergott Co., 11 T. C. 47 (1948), affd. (C. A. 3, 1949) 176 F. 2d 860, where, in commenting on petitioner's *78 failure to claim a deduction in earlier years because of the erroneous accounting treatment of an item and its attempt to presently claim the deduction, we said at pages 50-51: Such a process would not properly reflect the petitioner's income at the time, and the attempt to compensate for that error now by a procedure equally unsound, even though compensatory, may not be permitted to succeed. If petitioner improperly increased its income in much earlier years, * * * that is an error which it is now too late to correct. Cf. American Light & Traction Co., 42 B. T. A. 1121; affd. (C. C. A. 7th Cir.), 125 Fed. (2d) 365. * * * Also, there are no facts in the record which justify our holding that the respondent is estopped, as petitioner contends. Accordingly, we hold for the respondent on the only issue involved. See Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931). The petitioner has conceded the correctness of the depreciation adjustment, therefore, Decision will be entered for the respondent. Footnotes 1. All section references are to the Internal Revenue Code of 1939, as amended.↩ 2. SEC. 23. DEDUCTIONS FROM GROSS INCOME. (f) Losses by Corporations. -- In the case of a corporation, losses sustained during the taxable year and not compensated for by insurance or otherwise.↩